HO23: METHODS OF INVESTMENT APPRAISAL


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1 HO23: METHODS OF INVESTMENT APPRAISAL After completing this exercise you will be able to: Calculate and compare the different returns on an investment using the ROI, NPV, IRR functions. Investments: Discounting, Present and Future Values The term discounting refers to the estimation of the present value of future cash flows. For example, every 1 you have in your pocket today will have a different value in the future. If you deposit 100 in a savings account that returns a 6.5% annual rate of interest, your 100 will be worth in one year. In other words its future value is If interest rates remain fixed at 6.5% then after five years your 100 would be worth , i.e. the future value of 100 in five years time at an annual rate of interest of 6.5% = 100 x x x x x = Alternatively you may want to know the present value of 100 that you will receive in five years time. You can calculate the present value of your future 100, again assuming a rate of return of 6.5% = = You will examine the significance of discounting, present and future values in more detail below. But first a recap on the terms used in financial functions: Terms in Financial Functions rate: nper: pmt: pv: fv: type: The interest rate per period. The number of payment periods. The payment made each period. Remains unchanged over the life of the loan or annuity. The present value of an investment, or the original amount invested. The future value of an investment, or the cash balance you want to attain after the last payment is made. If fv is omitted it is assumed to be zero (fv = 0 for a loan) Indicates when payments are due: type= 0, payments due at end of period; type= 1, payments due at beginning of period; If omitted type is assumed to be zero. RATE(nper, pmt,pv,fv,type) Returns the interest rate per period of a given investment. For example: What interest rate do you need to double the value of an investment of 1000 over 10 years? Interest Rate =RATE(10,0,1000,2000) =7.2% What interest rate do you need to generate 15,000 at the end of 5 years if you are depositing 2,000 per year into an investment account? Interest Rate =RATE(5,2000,0,15000) = 20.4% How would the interest rate be affected if your account has an initial balance of 2,389? In this case the Interest Rate required =RATE(5,2000,2389,15000) = 7.4% NPER(rate,pmt,PV,fv,type) Calculates the number of payments required for an investment of present value (PV) to reach a future value (fv) while earning interest at rate. For example, how long will it take you to save 50,000 if the balance on your savings is currently 633 and you intend to bpho23.doc Page 1 of 5
2 deposit 2,000 at the end of each year? Assuming an interest rate of 11.5%, time needed: = NPER(11.5%,2000,633,50000) = years. FV(rate,nper,pmt,PV,type) Returns the future value of an investment where periodic payments (pmt) are invested for a number of periods (nper) at interest rate. PV and type are optional: type is 0 if payments are made at the end of the period, 1 if made at the start. Conventionally you use a negative number when money is paid out of your pocket, and a positive number when money is paid to you. For example: If you put 500 each year into a savings account earning 15% interest per annum then the value of your savings after 6 years =FV(15%,6,500) = 4, If you currently have savings of 340 and decide to invest 250 each year for the next 10 years into an account earning interest at 15% per annum, then the value of your savings at the end of the period: = FV(15%,10,250,340) = if you deposited your money at the end of the month, OR = FV(15%,10,250,340,1) = if you deposited your money at the beginning of the month. PV(rate,nper,pmt,fv,type) Returns the present value of an investment. For example, you have just won a prize which is either: 20,000 per year for the next 12 years or a 30,000 bond which matures in 15 years. Which should you choose? Assume you will invest the regular payment at 10%. The present value of the regular payment = PV(10%,12,2000) = 136, The present value of the bond = PV(10%,15,0,30000) = 71, No contest! Comparison of Methods of Investment Appraisal: Payback, ROI, IRR and NPV. PAYBACK PERIOD The payback period is the length of time it takes to recover an initial investment from its annual cash flows. For example, assume that Bacchus Wines decides to open a new wine store at a cost of 220,000. Suppose, after taking into account the sales revenue from the store, business expenses and depreciation, it takes Bacchus 30 months to earn back the 220,000, then the payback period for this investment is 2.5 years. Note: there is no Excel Function for this, but the payback period is easily calculated. RATE OF RETURN ON INVESTMENT (ROI) The Average Rate of Return on an Investment (ROI) = Profit (per annum) Initial Investment. For example, assume that after 3 years Bacchus Wines makes of an overall profit of 60,000 on its new wine store. The profit per annum = 60,000 3 = 20,000. The initial investment = 220,000. Thus ROI = ( ) x 100 = 9.0%. As discussed above 100 today is not worth the same as 100 in five years time. In this respect, Payback and ROI both suffer from a major limitation, neither takes into account the time value of money. This limitation is overcome by two other Excel's functions, NPV and IRR. NPV(rate,values) Rate is the discount rate. Values is the range of cells containing the cash flows. bpho23.doc Page 2 of 5
3 NPV returns the net present value of an investment based on a series of cash flows (receipts or payments). A negative NPV means that the rate of return on the project is less than the discount rate, and it would have been better to have kept the money in the bank at the given rate of interest. In deciding on whether to invest in a particular project, you would generally accept projects with positive NPVs, the larger the NPV the better. However there is a need to NPV against the Payback Period. IRR(values,guess) Values is the range of cells containing the cash flows; guess provides an estimate of the final result, if nothing is entered Excel assumes a value of 10%. IRR returns the internal rate of return for an investment (i.e. a measure of its profitability), without financing costs or reinvestment gains. If IRR is less than the Discount Rate then NPV will be negative. The higher IRR the more positive the value of NPV. A Worked Example 1. Bacchus has the opportunity of investing in a project, which requires an initial investment of 60,000, but which will generate cash flows (receipts) of 10,000 per year for the following 10 years. Calculate (a) the Payback Period and (b) the ROI of the project. 2. If the discount rate is 15% calculate whether the project is worth undertaking, using (a) NPV and (b) IRR. 3. Insert a new worksheet and rename it ho23. Then construct a table that calculates the required values: 4. Finally add a scroll bar or spinner control that enables the user to perform whatif calculations by changing the value of the discount rate: bpho23.doc Page 3 of 5
4 An Investment Decision  Which Project? 5. Bacchus Wines has to choose between 3 projects, each costing 100,000 to implement: Project A involves the purchase of new equipment. Project B involves a promotional campaign to boost membership/sales. Project C involves rationalisation of the stores department. 6. It is estimated that the projects will generate the cash flows shown in the table below: Year Project A Project B Project C Investment: 0100, , ,000 Cash InFlows: 1 10,000 60,000 35, ,000 40,000 30, ,000 20,000 30, ,000 10,000 30, ,000 20, ,000 10, Calculate (a) the Payback Period and (b) the ROI of the project. 8. If the discount rate is 10% calculate (a) NPV and (b) IRR. 9. What project would you rank of greatest value to Bacchus on purely financial grounds? Would your decision change if the discount rate increased? Add a scroll bar or spinner control that enables you to perform WhatIf calculations by changing the value of the discount rate. FURTHER READING AND RESOURCES Making investment decisions using Excel: bpho23.doc Page 4 of 5
5 Investment Appraisal: Go with the cash flow: Calculate NPV and IRR in Excel: Use of the IRR Function in Excel: Using Excel for Finance: MS Excel as a Financial Calculator: page1 bpho23.doc Page 5 of 5
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